Magazine

Treading Warily In The Junkyard

November 06, 2005

Companies and leveraged-buyout firms seeking to float junk bonds are facing tougher times. Increasingly, they're having to scale back the amounts they raise, pay higher interest rates, and agree to more financial restrictions. At the start of this year, the market would finance almost anything. But now investors are starting to worry about the economy, rising rates, and the fact that they were probably too lax in assessing credit risks earlier in the year. "There's a turn in the market to more risk aversion and careful credit selection," says Michael Anderson, high-yield market strategist at Lehman Brothers Inc. ()

Investors have other concerns, too. The heady returns from junk bonds in the past two years are fast disappearing. Despite average yields of about 7%, the total return on junk bonds is close to zero so far this year, vs. back-to-back returns of 23% and 11%, in 2003 and 2004, respectively, according to KPD Investment Advisors, a high-yield research firm. The flood of money into junk-bond mutual funds has now reversed.

In the past month alone, investors have passed up significant new offerings, including an $850 million slice of financing for the leveraged buyout of luxury retailer Neiman Marcus Group Inc. and a $500 million piece of the $1.8 billion purchase of direct-marketing company Affinion Group from Cendant Corp. () They also balked at buying one-third of $550 million of bonds offered to pay a special dividend to investors in Roundy's Supermarkets Inc. Overall, investors bought a quarter less new junk paper in the nine months through September than in 2004.

As a result, companies and LBO outfits are tapping still-booming demand in the parallel market for leveraged loans. That $235 billion market is driven by hedge funds and new investment vehicles that pool loans from multiple issuers to diversify risk and add leverage to boost returns. The loans usually have shorter maturities than bonds and floating rather than fixed interest rates. That market is sopping up borrowing the junk market shuns, such as an extra $975 million of the Neiman buyout.

TIGHTER COVENANTS

While the loan alternative keeps the borrowing spigot open for companies, it has some significant downside for the junk-bond market. That's because LBO firms are piling on more leverage, increasing the risk of trouble whenever the economy next stalls and sets off defaults. Large LBO deals in the third quarter carried debt averaging 6.1 times earnings before interest, taxes, depreciation, and amortization, vs. 4.6 times in 2003, according to LCD, a unit of Standard & Poor's (). The previous annual peak was in 1997 at 5.7 times. "Lenders have embraced ever more aggressive financing structures," says LCD director Christopher Donnelly.

All the same, new doubts about the market are unlikely to shut off access for additional LBOs and acquisitions. Several are pending, including the proposed $15 billion LBO of Hertz Corp. from Ford Motor (), IntelSat's acquisition of PanAmSat (), and R.H. Donnelley's () acquisition of yellow pages publisher Dex Media Inc (). Even at their present 3.3 percentage points above 10-year Treasuries, junk-bond market spreads remain cheaper than the average of 4.1 percentage points over the past 12 years, according to KDP. "The high-yield market will still be encouraging to LBOs, but it will be at a higher cost and not as generous on the terms," says John Fenn, high-yield market strategist at Citigroup (). Deals financed the past six weeks have featured both higher yields and more restrictive covenants, such as limits on asset sales by the borrower and on using bond proceeds to pay dividends, says Paul D. Scanlon, lead portfolio manager for high-yield funds at Putnam Investments.

The current bout of nerves among some investors isn't the first this year. In March and April, the junk-bond market swooned, falling 4% as $40 billion of General Motors Corp. () debt was cut to junk status. The GM debt amounted to about 6% of outstanding junk bonds, according to Lehman Brothers ().

That episode turned out to be just a really bad case of indigestion rather than a devastating malady, and the market bounced back. Next time around, though, investors might not be so lucky.